Thursday, April 8, 2010

Does A Roth Conversion Make Sense?

2010 has been heralded as "the year of the Roth" in numerous investment publications. It's easy to see why - the tax laws that govern income limits on Roth investments were modified so that the limitations were removed at the start of 2010.Does A Roth Conversion Make Sense_qmark

Prior to that change, Roth IRA accounts were off limits to individuals earning more than $120,000 and married couples earning more than $176,000. But now, anyone can open a Roth IRA, so it's no wonder that the financial media is awash in articles extolling the virtues of converting your traditional IRA into a Roth IRA, but does that really make sense?

I'm not going to offer a fancy calculator to show you how much money you could save by converting your IRA to a Roth - you can find many on the web. I just want to share some of the thoughts I've been turning over in my mind and maybe get you to think about the process a little more than before you read this.

Converting your traditional IRA to a Roth IRA account does make sense - for wall street.

I'm not running for office any time soon, so I'm not going to vilify Wall Street. Suffice it to say, every transaction on the stock market is making someone on Wall Street some money... usually many someones. All of that money is coming out of your IRA savings. I'm not saying that this is reason alone for skipping a Roth conversion, but it's something to consider.

Converting to a Roth can be taxing.

The simple difference between a tradition IRA and a Roth IRA is taxes - with a traditional IRA, you pay taxes when you take the money out; with a Roth IRA, you pay taxes on the money before you contribute it to your Roth account but the money you withdrawal in retirement is tax free. It's simplification as there are other differences, but it really boils down to paying taxes now vs. when you retire.

But when you convert your tradition IRA to a Roth, you are in essence transforming that money from pre-tax contributions (traditional IRA) to after tax contributions (Roth IRA), so you have to pay taxes on the amount you are converting.

But it's worse than that - the conversion amount is treated as income! For example, if you make $50,000 a year and you're converting a $100,000 IRA, then your income for tax purposes is effectively $150,000 for that year.

Traditional IRA accounts and Roth IRA accounts are not mutually exclusive.

What I mean by this is that you don't have to choose one of the other - you can have both!

These 3 factors have led me to conclude that IRA conversions are not worth doing.

What does make sense.

I still believe that a Roth IRA account is worth having. I don't see any way that tax rates will be less 20 years from now, and the tax free withdrawals of a Roth will be a big benefit by then. Couple that with the fact that you don't simply withdraw all your retirement savings upon retirement - you take a little bit at a time, leaving the rest to grow - and I think it makes sense to have both a traditional IRA and a Roth IRA.

The traditional IRA should be depleted first, since that gives the Roth even more time to grow tax-free. Also, a Roth IRA can be left to your beneficiaries, so if you pass away before you can tap the Roth, there's more left for your heirs.

I don't expect too many financial pros who make a living off of the commissions and fees generated by a Roth conversion to be espousing this idea, but I am surprised that I haven't seen this in any of the finance media like Morningstar, Kiplinger, Money, etc... it makes me wonder if I'm not missing something big with the whole concept.


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